Retroactive Tax Increases and The Constitution

I
looked in a number of books for a good joke about taxes, but I
couldn't find any. I then realized why: There's absolutely nothing
funny about taxes, especially on April 15.

I
did, however, find a great example of a Democrat condemning
burdensome taxation:

When more of the people's sustenance is
exacted through the form of taxation than is necessary to meet the
just obligations of government and expenses of its economical
administration, such exaction becomes ruthless extortion and a
violation of the fundamental principles of free government.1

I
couldn't have said it better myself.

Two
things inspired me to write a book about retroactive legislation.
The first is the Superfund Law, which, as many of you know,
retroactively imposes strict, joint, and several liability on firms
that disposed of wastes long before the bill was passed in 1980.
The Comprehensive Environmental Response, Compensation, and
Liability Act of 1980 (CERCLA)2 is, in a sense, a kind
of retroactive tax, but it is imposed on those whom the government
is easiest able to catch, and it may be imposed on someone whose
actions may have been entirely reasonable and lawful at the time
that he engaged in them.

The
second event that inspired me to write the book was Bill Clinton's
retroactive tax increase in 1993. In fact, as I learned, as
retroactive tax increases go, Clinton's was not so bad and
certainly not unprecedented. There have been far, far worse
retroactive tax increases. Because I am speaking with Hill
staffers, and you all love anecdotes, let me offer a few.

In
the early 1980s, Congress created a tax deduction to encourage
people to sell stock in a company to that company's employee stock
option plan (ESOP). To get the benefit of that deduction, Jerry W.
Carlton, the executor of the estate of Willametta K. Day, sold
stock to an ESOP at a loss. Engaging in what Justice Antonin Scalia
later called "bait and switch" taxation, Congress in 1986 repealed
the tax deduction and applied the repeal retroactively, costing the
estate more than $600,000. Justice Scalia's comment
notwithstanding, the Supreme Court unanimously upheld the
government's assessment of the tax.

In
April 1976, E. M. Darusmont was notified by his Houston employer
that he was to be transferred. He and his wife, of course, had to
sell their home, which was a three-family house; they had rented
the other two parts of the house to help pay the mortgage. The
Darusmonts engaged a firm to advise them how best to sell the house
to minimize the tax consequences. After weighing those different
tax consequences, they sold the home outright, recognizing a gain
of $51,000 or so. Under the rules then in effect, they had to pay
tax on only half that amount. Then, in October, President Gerald
Ford signed the Tax Reform Act of 1976, which retroactively
increased the minimum tax. The Darusmonts had to pay an additional
$2,280, which, for a family like the Darusmonts, in 1976 dollars,
was not an insubstantial sum. This outcome wholly undercut their
planning, yet the Supreme Court upheld the government's assessment
of the tax.3

More
outrageous still is a case in which the Internal Revenue Service
(IRS) released final rules in 1993, which it applied retroactively
to tax years effective for 1984. In this case, the IRS changed the
rules for when a company can deduct interest owed to a foreigner,
from when it is accrued to when it is paid. Companies needed to
re-file returns going back as long as 10 years. The Third Circuit
upheld the rule as within the IRS's authority because section
7805(b) of the Internal Revenue Code states that "The Secretary may
prescribe the extent, if any, to which any ruling or regulation
relating to the internal revenue laws, shall be applied without
retroactive effect." The court held that "Clearly Congress has
determined that treasury regulations are presumed to apply
retroactively."

LESSONS
LEARNED

At
least three lessons emerge from these stories: First, that Congress
is at fault for the imposition of retroactive tax liability,
although, in every case, it was a Democratic Congress that imposed
such a tax; second, the courts cannot be relied upon to protect
people from retroactive tax increases; and third, just because a
law may be constitutional doesn't mean that it's just or right.

Congress has been adopting retroactive tax
increases for a very long time, essentially since the 1930s. The
1913 Revenue Act was the first one with an effective date before
the date of the actual enactment. Generally, the increased tax rate
is applied retroactively to the year in which it is enacted. But in
1918 and 1926, each of the Revenue Acts was applied to the entire
calendar year that had preceded enactment. As early as 1935, one
commentator pronounced restrictions on retroactive taxation to be
"dead."

These laws were bad in their own right.
They were also bad because they paved the way for the retroactive
imposition of many other forms of liability. Since the 1930s, the
courts have tolerated such retroactive legislation. The Supreme
Court has narrowly construed most of the traditional constitutional
protections against retroactive laws. Many Americans mistakenly
believe that retroactive legislation is barred by the ex post
facto clauses, which apply to both Congress and state
legislatures. Since at least the early part of the 1800s, though,
the ex post facto clauses have been interpreted as applying
to criminal laws only.

Almost as disturbing is that the Supreme
Court has been expanding its definition of what is "civil" and
narrowing its definition of what is "criminal." This further
reduces the scope and effect of the ex post facto
clauses.

The
Bill of Attainder Clauses, which also constrain state and federal
governments, provide only limited protection against retroactive
civil legislation. Although the Supreme Court has construed these
clauses as protecting rights, the clauses bar only those laws that
legislatively determine guilt and inflict punishment on
identifiable individuals without the protections of a judicial
trial. The Supreme Court has not struck down a law as an
unconstitutional bill of attainder since the mid-1960s.

The
Contracts Clause once operated as a firm bar against redistributive
legislation by states that violated existing contract rights by
transferring the benefits of the bargain from one contracting party
to another. The clause was intended particularly to prevent
legislation that relieved debtors at the expense of their
creditors. The clause was often invoked during the 19th century. In
1934, however, the New Deal-era Supreme Court refused to read the
clause in accordance with its original understanding, and upheld
debtor-relief legislation. Since that time, the Contracts Clause
has rarely served as an impediment to retroactive laws. In any
event, the Contracts Clause applies only to the states.

The
Takings Clause has met with much the same fate as the Contracts
Clause. Once a key impediment to laws that upset existing economic
circumstances without compensation, the Takings Clause is now
applied only in a few, extreme situations. The Supreme Court will
require compensation for physical invasions, and where regulation
deprives a property owner of all economically beneficial or
productive use of land. A few scholars have been heralding a
revival of the Takings Clause, but that revival has yet to
materialize.

Some
have declared retroactive legislation to be beyond the power of the
legislature or a violation of due process. Given the history of
retroactive legislation, it is not credible to declare all
retroactive legislation beyond the power of Congress. Certain
retroactive laws that have intruded into the judicial power have
been found unconstitutional, but this covers a relatively small
class of cases.

There is the temptation to contend that
legislative deprivation of a "vested right" offends due process.
The difficulty with this argument is that there is no way to define
a "vested right" outside the context of the Takings and Contracts
Clauses. Vested rights are defined as those that are beyond
the power of the legislature to upset, and retroactive
legislation is defined as a law that upsets vested rights. The
definitions are entirely circular. Moreover, the Supreme Court has
upheld against a due process challenge even the law, described
above, that retroactively withdrew a tax break created by Congress
that specifically induced an individual to sell stock at a loss to
take advantage of the tax break.

There are more promising developments in
the administrative law context, however. Courts have begun to
restrict the ability of administrative agencies to punish companies
when they adopt a new interpretation of a regulation. If the
company genuinely tried to adhere to the law, and adopted a
reasonable interpretation of the law, the courts have prevented
agencies from imposing fines. Courts have made this decision even
when they upheld the agency's new interpretation on a prospective
basis.

BACK TO THE
FUTURE?

It
is not likely that the courts will soon breathe enough life into
the ex post facto, Contracts, and Takings Clauses to make them
significant impediments to retroactive legislation. Action is
therefore up to Congress.

First, Senator Strom
Thurmond (R-SC) has introduced a bill that would establish a
presumption that all statutes apply prospectively, unless they
expressly state, in the text of the statute, that they apply
retroactively. This is an easy change to make; it wouldn't even
really constrain Congress's future actions, but it would help in
cases of ambiguity. It is also consistent with the way that
Anglo-American law has traditionally dealt with retroactive
legislation. Generally, courts try to avoid the problem by
construing ambiguous statutes to apply prospectively. This would
enshrine that principle in a statute.

Second, Congress should
reverse the presumption that Treasury regulations apply
retroactively. As is the case with most administrative rules, they
should apply prospectively.

Third, laws that
expressly refer to, and change, the past legal consequences of past
events should be made subject to a super-majority requirement.
Certainly this can be applied to retroactive tax increases. In
fact, the House, during the 104th Congress, already passed an
internal rule declaring retroactive tax increases out of order, and
Senator Paul Coverdell (R-GA) pushed a similar reform through a
Senate committee.

Fourth, Congress should
pass legislation requiring the originating committee, or the
comptroller general, to assess the effect of proposed legislation
on investment-backed expectations. Bills determined to be
retroactive should be declared out-of-order. This is consistent
with the proposed Common Sense Legal Reforms Act of 1995, which
would have required the committee report on any legislation "of a
public character" to specify the "retroactive applicability, if
any, of that bill or joint resolution." It adds teeth to that
determination by making bills determined to be retroactive harder
to pass.

Fifth, administrative
agencies should also be precluded from enforcing statutes or
regulations against individuals in certain instances. First, if the
regulation is so ambiguous that it did not include fair notice;
second, the individual reasonably relied on a written statement of
agency policy that takes a different view; and third, the agency
has not interpreted the statute or regulation and the individual's
reading of it is reasonable.

A
retroactive executive order, requiring agencies to assess the
effects of their actions on investment-backed expectations, will
also help raise consciousness about the unfair nature of
retroactive rule making. At this stage, however, until these
reforms are tried, a constitutional amendment banning retroactive
legislation is not a good idea, in part because of the
difficulties, which I have not discussed, in assessing when
legislation is retroactive.

Most
important of all is the need to build a political consensus against
such laws. Everyone opposes changing the rules after the game has
been played. People respond to stories about individuals having had
the rug pulled out from under them. Retroactive laws are hostile to
fundamental fairness. Let us make their existence a political
issue, so that a consensus can form urging that they be prohibited
entirely, except where curative.

Finally, a vigorous discussion of this
subject might lead more people to conclude that, if it is not
necessary to change, it is necessary not to change.

--Daniel E. Troy is an Associate
Scholar at the American Enterprise Institute and a partner at
Wiley, Rein & Fielding.

Rep. Peter Roskam (R-IL) says it's "a great way to start the day for any conservative who wants to get America back on track."

Sign up to start your free subscription today!

Sorry! Your form had errors:

About The Heritage Foundation

The Heritage Foundation is the nation’s most broadly supported public policy research institute, with hundreds of thousands of individual, foundation and corporate donors. Heritage, founded in February 1973, has a staff of 275 and an annual expense budget of $82.4 million.

Our mission is to formulate and promote conservative public policies based on the principles of free enterprise, limited government, individual freedom, traditional American values, and a strong national defense. Read More